CUNA Regulatory Comment Call

May 25, 2004

Revisions to Policy Statement on Payments System Risk(NOT A MAJOR PROPOSAL)

EXECUTIVE SUMMARY

The Federal Reserve Board requested comment on proposed revisions to Part II of its Policy
Statement on Payments System Risk (PSR Policy), which addresses risk management in payments and
securities settlement systems. No changes will be made to the Federal Reserve Daylight Credit Policies.
This policy is of interest to credit unions because the Federal Reserve System is one of the largest
providers of payment services and how the Federal Reserve alters the PSR Policy to manage and prevent
risks should affect those credit unions and other financial institutions that rely on the Federal Reserve
for payment services.

The proposed revisions update the policy in light of current industry and supervisory risk
management approaches and new international risk management standards for payments and securities
settlement systems. In addition, they provide further clarification regarding the policys objectives,
scope, and application.

The key revisions include an expansion of the policys scope to include those Federal Reserve
Bank payments and securities settlement systems that meet the policys application criteria, revised
general risk management expectations for systems subject to the policy, and the incorporation of both the
Core Principles for Systemically Important Payment Systems (Core Principles) and the Recommendations for
Securities Settlement Systems (Recommendations).

Comments are due to the Federal Reserve by July 26, 2004. Please submit your comment to CUNA by
July 7, 2004.

The policy changes proposed by the Board include changes to the scope of the policy to include payments
and securities settlement systems operated by the Reserve Banks, establishment of clearer risk-management
expectations for all systems subject to the policy based on current industry and supervisory risk-management
concepts, and incorporation of the Core Principles and Recommendations as the Boards risk-management
standards for systemically important payments and securities settlement systems, respectively. The Board is
also proposing a new introduction to and reordering of the current parts of the PSR policy in order to
provide a more coherent framework for the overall policy and better communicate the Boards concerns and
objectives regarding payments systems risk. The proposed changes do not affect the current Part I of the PSR
Policy that concerns Federal Reserve daylight credit policies except to renumber this part of the policy as
the new Part II.

The Board believes that these proposed structural and substantive changes more clearly ground the PSR
policy in the Boards high-level objectives, provide a more coherent structure for the overall policy, and
better communicate the Boards concerns about risks for the nations payments and securities settlement
system and the implications of these risks for the Federal Reserve. In particular, the Board revised the
introduction to the overall policy to include a clear statement of the Boards public policy objectives and
provide a general discussion of the types of risks encountered in settling payments and securities
transactions, how those risks arise, and why the Board believes they must be controlled.

Changes to the Policys Scope, Definitions, and Application. The proposed policy extends its scope to
include payments and securities settlement systems operated by the Reserve Banks, which is consistent with
the Core Principles and the Recommendations. The scope continues to cover those private-sector payments
systems that expect to settle an aggregate gross value exceeding $5 billion on any day during the next
twelve-month period and extends the same threshold to private-sector securities settlement systems and
Reserve Bank payments and securities systems. While the direct application of the policy will be limited to
those systems above the threshold, the Board encourages all payments and securities settlement systems to
consider the risk-management approach set out in the policy.

The proposed policy also clarifies the definition of a system for purposes of applying the policy,
defining a system to be a multilateral arrangement (three or more participants) among financial institutions
for the purposes of clearing, netting, and/or settling funds or securities transactions among themselves or
between each of them and a central party. This definition also identifies three key characteristics of
systems, which would be used individually or in combination, to determine if an arrangement qualifies as a
system for purposes of the policy: (1) a set of rules and procedures, common to all participants, that govern
the clearing (comparison and/or netting) and settlement of payments or securities transactions, (2) a common
technical infrastructure for conducting the clearing or settlement process, and (3) a risk-management or
capital structure in which credit losses are ultimately borne by system participants rather than by the
system operator, a central counterpart or guarantor, or the systems shareholders. Futures and option
clearing organizations and correspondent banking services continue to be excluded from the coverage of the
policy.

Finally, new language clarifies how the policy will be applied by the Board, both when the Board exercises
its existing authority and, if it goes not have direct or exclusive authority, when it works with other
authorities to promote the aims of the policy.

Changes to the General Policy Expectations. The proposed policy sets out revised risk-management
expectations for all systems covered by the policy, including those seemed as systemically important. Under
the current policy, systems are asked to identify the risk factors present in their systems, assess whether
the systems policies and procedures adequately address the identified risks, and, if necessary, improve
their policies and procedures such that risk-management controls are proportional to the nature and magnitude
of the risks in the system. The current policy provides limited illustrative examples of risk-management
controls that a system might employ to address various risks (for example, credit, liquidity, operational,
and legal risks), but does not provide guidance for addressing risk management in an integrated manner. The
current policys general approach was intended to provide flexibility, with an expectation that systems would
implement a risk-management framework appropriate for the risks the system poses to the system operator,
system participants, and the financial system more broadly. In practice, however, the Board has found that
the current policys approach lacks sufficient structure to provide useful guidance to systems. The proposed
revisions continue to provide flexibility but set out four key elements of a sound risk-management framework
that the Board believes will provide systems with more structured guidance. These elements are based on a
review of current industry and supervisory concepts of sound risk management: (1) clearly identify risks and
set sound risk-management objectives; (2) establish sound governance arrangements; (3) establish clear and
appropriate rules and procedures; and (4) ensure the employment of the resources necessary to implement the
systems risk-management objectives and implement effectively its rules and procedures.

Incorporation of the Core Principles and Recommendations. The proposed policy adopts the Core Principles
and the Recommendations with no modifications and presents them as the Boards standards for systemically
important systems. Private-sector systems currently expected to meet the Lamfalussy Minimum Standards would,
under the proposed policy, be expected to comply with the Core Principles. Similarly, private-sector systems
currently subject to the Boards policy requirement for delivery-against-payment systems would be expected to
comply with the relevant portions of the Recommendations. As noted below, the Core Principles and the
Recommendations would apply to Reserve Banks payments and securities settlement systems that meet the
relevant policy criteria.

The proposed policy introduces six characteristics that would be used by the Board, on a case-by-case
basis, to identify systems, including Federal Reserve systems that would be considered systemically
important. To determine whether a system is systemically important for the purposes of this policy, the
Board may consider, but will not be limited to, one or more of the following factors:

Whether the system has the potential to create significant liquidity
disruptions or dislocations should it fail to perform or settle as expected;

Whether the system has the potential to create large credit or liquidity
exposures relative to participants financial capacity;

Whether the system settles a high proportion of large-value or inter-bank
transactions;

Whether the system settles transactions for critical financial markets
(markets for federal funds, foreign exchange, and commercial paper; U.S. government
and agency securities; and corporate debt and equity securities);

Whether the system provides settlement for other systems;

Whether the system is the only system or one of a very few systems for
settlement of a given financial instrument.

In applying the standards to systemically important systems, the policy seeks to be flexible, recognizing
that systems differ in the specific instruments they settle, the markets and institutions they serve, and the
legal and regulatory constraints under which they operate. The policy states that these factors will be
considered when assessing the way in which a systemically important system addresses any particular standard.

QUESTIONS REGARDING THE PROPOSAL

Do the benefits of a bright line quantitative threshold based on a systems daily gross settlement
value outweigh the costs of using more complex factors to determine whether a system is covered by the
policy? Should more qualitative or judgmental criteria be used instead? If a quantitative threshold is
appropriate, does a threshold of $5 billion a day continue to be reasonable? Should other quantitative
criteria be considered? Please explain.

Is the definition of what constitutes a system, and explicit exemptions from this definition
reasonable and appropriate? The proposed policy also clarifies the definition of a system for purposes
of applying the policy, defining a system to be a multilateral arrangement (three or more participants)
among financial institutions for the purposes of clearing, netting, and/or settling funds or securities
transactions among themselves or between each of them and a central party. Please explain.

Do the general policy expectations of a sound risk-management framework, laid out in part B of the
revised policy, give more structure and specific guidance to system operators and participants than the
current policys primary focus on types of risks and the general need to manage these risks? The
proposed revisions continue to provide flexibility but set out four key elements of a sound risk-
management framework that the Board believes will provide systems with more structured guidance. These
elements are based on a review of current industry and supervisory concepts of sound risk management: (1)
clearly identify risks and set sound risk-management objectives; (2) establish sound governance
arrangements; (3) establish clear and appropriate rules and procedures; and (4) ensure the employment of
the resources necessary to implement the systems risk-management objectives and implement effectively
its rules and procedures. Please explain.

In applying the Core Principles and the Recommendations, do the six criteria presented in the
proposed policy appear reasonable for determining if a system is systemically important (i.e. whether the
system has the potential to create significant liquidity disruptions or dislocations should it fail to
perform or settle as expected; whether the system has the potential to create large credit or liquidity
exposures relative to participants financial capacity; whether the system settles a high proportion of
large-value or inter-bank transactions; whether the system settles transactions for critical financial
markets (markets for federal funds, foreign exchange, and commercial paper; U.S. government and agency
securities; and corporate debt and equity securities); whether the system provides settlement for other
systems; whether the system is the only system or one of a very few systems for settlement of a given
financial instrument). Are there other factors that the Board should consider when determining whether a
system is systemically important? Please explain.